Virtual Reality: IRS Provides Guidance on the Treatment of Bitcoin and Other Virtual Currency Transactions

On March 25, 2014, the Internal Revenue Service (IRS) issued Notice 2014-21 (the Notice), which provides guidance regarding the tax treatment of Bitcoins and other virtual currency through a series of “frequently asked questions” (FAQs). The Notice provides that virtual currency is property, rather than foreign currency, for federal income tax purposes, and the FAQ responses address the practical implications of that characterization, including important details regarding the reporting and withholding requirements related to virtual currency transactions. The Notice is not intended to address all tax considerations with respect to virtual currency, which was identified by the Taxpayer Advocate as one of the top 25 issues facing the IRS, but it is a significant starting point. The Notice invites comments on additional tax considerations that may be relevant to virtual currency transactions.

This Legal Alert summarizes the guidance provided in the Notice and addresses the practical implications of the Notice for taxpayers that are engaged in transactions in virtual currency. As discussed below, note that some issues still remain open. Click here for the full text of the Notice.

Summary of Guidance

The Notice is directed specifically at virtual currency that can be digitally converted into real currency and exchanged for goods or services. Bitcoins, which are the most widely recognized virtual currency, appear to be the focus of the Notice, but virtual currencies with similar properties also would be impacted. The Notice does not address currencies that cannot be converted into real currency, such as currencies or points systems that may be used in online games, the taxation of which also has been the subject of some discussion.

The Notice treats virtual currency as property, not as currency, for U.S. federal income tax purposes. This treatment is similar to the approach recently taken by certain jurisdictions, including Canada, which applies barter transaction rules when virtual currencies are used to purchase goods or services. However, the Notice departs from the approach taken by other jurisdictions, including the United Kingdom, which is treating virtual currencies more like a government-backed currency and have stopped charging value-added tax on the value of the virtual currencies when they are exchanged for real national currencies. The vast majority of foreign jurisdictions have not released official positions on the treatment of virtual currencies, while a small number of foreign jurisdictions, including China, have restricted the use of such virtual currencies.

The treatment of virtual currency as property for U.S. federal income tax purposes means that, except in the case of taxpayers that sell and exchange virtual currency in the course of a trade or business, income and loss from transactions in virtual currency are treated as giving rise to capital gain or loss.

For taxpayer’s making longer-term investments in virtual currency (i.e., more than one year), this means that income may be taxed at lower capital gains rates. However, the use of capital losses may be limited because they generally can be used only to offset capital gains. If virtual currency instead were treated as currency for tax purposes, gains and losses with respect to such currency generally would give rise to ordinary income or loss. In that case, taxpayers holding virtual currency for more than one year gains would be subject to higher tax rates rather than capital gains rates, but there would be no limitations on the use of losses.

Consistent with the treatment of virtual currency as property, the Notice provides that:

A recipient of virtual currency as payment for goods and services must include the fair market value (FMV) of the virtual currency in computing its gross income, and it would have an FMV basis in the virtual currency received;

The payer in such a transaction has gain or loss upon the disposition of its virtual currency for cash or in exchange for goods and services, determined as the difference between its basis in the virtual currency and the FMV of the virtual currency at the time of the transaction;

Virtual currency “miners” have income upon the receipt of the virtual currency, and may be subject to self-employment tax or FICA if they are “mining” virtual currency in the course of a trade or business; and

The general Information reporting and withholding rules apply to transactions in virtual currency, just as they apply to other transactions in property, meaning generally that transactions in virtual currency exceeding $600 are required to be reported to the payer and the IRS, unless an exception applies.

The FMV of virtual currency transactions is determined based on the price of the virtual currency on virtual currency exchanges on the transaction date.

Practical Implications

Many different types of players have entered the virtual currency market as the popularity of virtual currency, and particularly Bitcoins, has continued to grow. Some of the practical implications of the FAQs for taxpayers that are engaged in virtual currency transactions include:

Individual taxpayers that have significant losses from virtual currency trading may find that they are limited in their ability to use those capital losses. As noted above, taxpayers that have gains on virtual currency held for more than one year may be able to take advantage of lower capital gains rates; although, given the relatively recent rise in popularity of virtual currency, it is not clear that this benefit will be available to many taxpayers.

Each time a taxpayer purchases goods with virtual currency, the taxpayer is required to calculate, and ultimately report to the IRS on its return, the amount of the gain or loss on the virtual currency used in the transaction. For regular users of virtual currency, this results in significant administrative burdens, which may be compounded by the fact that virtual currencies are traded on multiple exchanges and have been subject to significant valuation swings, even within a single day.

Virtual currency mining may constitute a trade or business, which may permit taxpayers engaged in virtual currency mining to take deductions for ordinary and necessary expenses related to their mining activities. However, it also may subject the miners to self-employment taxes or FICA on the income from their mining activities.

The IRS did not provide relief for taxpayers that have already filed current or prior year returns in a manner that is inconsistent with the new guidance. Those taxpayers will need to consider filing amended returns consistent with this guidance. The IRS stated that it would take into account reasonable cause arguments in determining whether a taxpayer in such a position is subject to penalties. The availability of the reasonable cause exception may be affected by whether a taxpayer takes steps to correct prior returns to reflect the guidance in the Notice.

Taxpayers that facilitate virtual currency transactions also are put on notice that they must ensure that they obtain sufficient information from their customers to satisfy IRS reporting and withholding obligations, or they could face stiff penalties. The application of reporting requirements to virtual currency transactions may discourage users of virtual currency that may have been attracted by the anonymity otherwise provided by virtual currency transactions.

Open Issues

The Notice recognizes that there may be questions regarding the tax treatment of virtual currencies not answered by the FAQs. Some of those issues may be currently apparent, and others will arise as the virtual currency market grows and evolves. Immediately apparent issues include the following:

U.S. virtual currency businesses, such as exchanges or hosted wallet providers, will have information reporting obligations to the IRS. It is currently unclear whether, and to what extent, foreign virtual currency businesses will have similar reporting obligations.

The Notice does not address whether virtual currency is considered a financial asset. A taxpayer may have FBAR and Form 8938 reporting obligations if virtual currency is held outside of the U.S.

Businesses that hold customer accounts in virtual currencies may be considered financial institutions. As such, foreign virtual currency businesses, such as hosted wallet providers and exchanges, may be subject to the Foreign Account Tax Compliance Act (FATCA).

The Notice suggests that further guidance may be provided by the IRS to address these and other open issues.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

"My best business intelligence, in one easy email…"

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.

Privacy Policy (Updated: October 8, 2015):

hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide

*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.